Getting the message (out) on value creation
As the concept of value creation takes on increasing
prominence, a cornucopia of new indicators has emerged to measure it: TSR, MVA,
EVA, CFROI, ROCE-WACC, and others with even weirder acronyms. No doubt these
will coalesce at some point in the future into a few value creation indicators,
such as happened with cash flow tables.
The current plethora does have the advantage of fostering healthy competition, which should normally allow the best indicator to emerge. More prosaically, some companies take advantage of the abundance and the lack of standardisation to pick and choose that indicator that best serves their interests of the moment and sometimes use a different one the following year...
The table below shows value creation indicators in chronological order, based on two criteria: to what extent they can be manipulated and to what extent are influenced by the financial markets.
Unsurprisingly, the indicators are clustered in a diagonal running northwest to southeast, with the company's ability to manipulate indicators falling as investor experience and the influence of financial markets increases.
- Profit indicators: until the mid-1980s, companies reported mainly their net profit or their earnings per share (EPS). These are two sterling parameters in accounting but also two that are subject to a certain amount of window dressing, including exceptional items, provisions, etc. The increasing focus on EBIT and EBITDA is progress, as it reduces the impact of exceptional items and charges considerably.
- Profitability indicators: further progress
is the recent focus on profitability, i.e. efficiency, based on the return
on the equity used to achieve that return. This is, naturally, called return
on equity, or ROE. This criterion is nonetheless subject to leverage, as a
judicious increase in debt levels most often increases this indicator without
necessarily creating value, as the increased risk cancels out the increased
Return on capital employed, or ROCE, avoids this bias and - with the exception of certain sectors, such as banking and insurance, where it makes no sense - is becoming more widely adopted as an indicator of operating performance.
- Value creation indicators: however, mere return is insufficient as a measure of value creation as it does not reflect the notion of risk. However, it can still be compared to the weighted average cost of capital (WACC or, simply, the cost of capital), to see if value has been created (i.e. if ROCE is higher than the cost of capital employed) or destroyed (the reverse).
Corporate communication can be based on this sole criterion. Suez, for example, has set a goal of ROCE at least 3 percentage points above its cost of capital. It can beat that target by applying it to capital employed at the beginning of the year to measure value created during the year, in which case it is expressed in euros and not as a percentage. This measure of value creation was brought into common use by Stern Stewart & Co. under the name of EVA (Economic Value Added). While the spreads between ROCE and cost of capital on the one hand and EVA on the other hand are operational in nature, they are influenced somewhat by the financial markets, which determine the cost of capital.
Market Value Added (MVA) and Total Shareholder
Return (TSR) are closely correlated to the state of the financial markets.
MVA reflects the difference between the value of equity capital and net debt,
and their book value; it is expressed in monetary units. TSR is expressed as
a percentage and is the sum of dividend yield (dividend/share price) and the
capital gain (capital gain during the period/initial share price). This is the
return for the shareholder who buys his shares at the beginning of the period
and sells them at the end. As a result - and this is their main weakness - these
two indicators can suggest that value is being destroyed (because of a decline
in anticipations of future profits), even as the company's ROCE has exceeded
its cost of capital. For example, Emap's share price has fallen by c.20% in
the last 12 months, even though its ROCE higher than 20% in 2003/04 vs. a cost
of capital of about 9%. On the other hand, during a phase of market euphoria,
a company with poor operating performances, can report strong TSR and MVA. True,
over the long term, the highs and lows are smoothed out, and a modest performances
will be reflected in its TSR and MVA; but in the meantime there can be considerable
Indicators of operating performance measures past performance, while indicators of market value creation (TSR and MVA) reflects much more the anticipation of future value creation reflected in the share price. They are therefore more complementary than contradictory.